Paper: arXiv 2303.08748

Authors: Lioba Heimbach, Eric Schertenleib, Roger Wattenhofer

Abstract

Lending protocols in decentralized finance enable the permissionless exchange of capital from lenders to borrowers without relying on a trusted third party for clearing or market-making. Interest rates are set by the supply and demand of capital according to a pre-defined function. In the lead-up to The Merge: Ethereum blockchain’s transition from proof-of-work (PoW) to proof-of-stake (PoS), a fraction of the Ethereum ecosystem announced plans of continuing with a PoW-chain. Owners of ETH - whether their ETH was borrowed or not - would hold the native tokens on each chain. This development alarmed lending protocols. They feared spiking ETH borrowing rates would lead to mass liquidations which could undermine their viability. Thus, the decentralized autonomous organization running the protocols saw no alternative to intervention - restricting users’ ability to borrow. We investigate the effects of the merge and the aforementioned intervention on the two biggest lending protocols on Ethereum: AAVE and Compound. Our analysis finds that borrowing rates were extremely volatile, jumping by two orders of magnitude, and borrowing at times reached 100% of the available funds. Despite this, no spike in mass liquidations or irretrievable loans materialized. Further, we are the first to quantify and analyze hard-fork-arbitrage, profiting from holding debt in the native blockchain token during a hard fork. We find that arbitrageurs transferred tokens to centralized exchanges which at the time were worth more than 13 Mio US$, money that was effectively extracted from the platforms’ lenders.

Complexity vs Empirical Score

  • Math Complexity: 3.0/10
  • Empirical Rigor: 7.5/10
  • Quadrant: Street Traders — practical and empirical, lighter on theory

Why this score: The paper provides a strong empirical analysis of a unique event in DeFi (The Merge), quantifying hard-fork arbitrage and rate dynamics across major lending protocols. While mathematical complexity is low, the novelty of the market mechanics studied and the empirical insights on liquidity and arbitrage extraction make it a highly valuable practical study.

Research Flowchart

  flowchart TD
    A[Research Goal: Impact of The Merge & Governance Interventions on AAVE & Compound] --> B[Data Inputs: On-chain Transaction Data, Borrowing Rates, & CEX Transfers]
    B --> C[Methodology: Quantify Rate Volatility, Utilization, Liquidations, & Hard-Fork Arbitrage]
    C --> D[Computational Analysis: Track Utilization Rates up to 100% & Value of Debt-Extracted ETH-PoW]
    D --> E[Outcome 1: Extreme Volatility & High Borrowing; No Mass Liquidations Materialized]
    D --> F[Outcome 2: Discovered >$13M USD Extracted by Arbitrageurs from Lenders to CEXs]